Bernanke, Japan's Lost Decade & US Lost Century

With the yields of Treasuries pointing towards the US re-entering recessionary straits, all eyes have turned towards the upcoming central banker jamboree at Jackson Hole this coming Friday. Although the Fed is supposed to be an independent central bank, the "new normal" of growth in the 1-2% range coined by PIMCO which even I find optimistic is not really a politically palatable status quo. It was not so long ago that central bankers were hailed as new heroes for licking inflation for good. Now, however, it seems they are being asked to perform superhuman feats in turning around the course of iceberg-bound US(S) Titanic. Nevermind that the first two rounds of quantitative easing failed to have lasting effects in obtaining sustained recovery, but many market participants are indeed clamouring for QE3. Such is the dysfunctional nature of US politics that meddling is called for at every turn. I, for one, disdain such busybody behaviour.

At this point, let us try and read the mind of Ben Bernanke. Central bankers are a conservative lot, but Bernanke has already been exceedingly adventurous in clogging up the Fed's balance sheet with mortgage-related assets of dubious quality in addition to near-ZIRP and the aforementioned quantitative easing involving purchases of government debt. As it turns out, aside from being a scholar of the Great Depression, Bernanke too has been an active commenter on turning around Japan's deflationary situation. While there are differences here and there--Japan's public debt is largely held domestically, Japan has a falling population and so forth--many now suggest that low yields on Treasuries portend America turning Japanese as the 80s song went.

Indeed, some credence for such a comparison comes from Bernanke himself. Trawling through the grisly entrails of Bernanke's history of academic writing and speechmaking, we glimpse his possible next moves after the non-events of QE1 and QE2. On 31 May 2003, Bernanke delivered a speech before the Japan Monetary Society of Monetary Economics. Aside from the now-familiar references to helicopter drops, he too describes Japan's situation in a manner which may be as good a description of present-day America after using a "find and replace" command to swap "Japan" with "United States":

Demand on the part of both consumers and potential purchasers of new capital equipment in Japan remains quite depressed, and resources are not being fully utilized. Normally, the central bank would respond to such a situation by lowering the short-term nominal interest rate, but that rate is now effectively zero. Other strategies for the central bank acting alone exist, including buying alternative assets to try to lower term or liquidity premiums and attempting to influence expectations of future inflation through announcements or commitments to expand the monetary base.

The Bank of Japan has taken some steps in these directions but has generally been reluctant to go as far as it might, in part because of the difficulty in determining the quantitative impact of such actions and in part because of the Bank's view that problems in the banking system have "jammed" the usual channels of monetary policy transmission. Ironically, this obvious reluctance on the part of the BOJ to sail into uncharted waters may have had the effect of muting the psychological impact of the nonstandard actions it has taken. Likewise the Bank of Japan has resisted calls to manage the value of the yen, citing its lack of authority to do so as well as the prospect of retaliation from trading partners.

What to do , then? A much-cited mimeograph by Bernanke while still at Princeton is on Japanese Monetary Policy: A Case for Self-Induced Paralysis? dating from 1999. Coming at the tail end of Japan's so-called Lost Decade, you can plausibly argue that this pre-Internet bust year was close to a turning point in the US economy as well. With income stagnant-to-falling in the subsequent years, it is little exaggeration to call the Noughties the US Lost Century. As you may have expected, getting out of a deflationary situation according to Bernanke involves parasitic behaviour in creating some inflation:

A problem with the current BOJ policy, however, is its vagueness. What precisely is meant by the phrase “until deflationary concerns subside”? Krugman and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation. Further, setting a quantitative inflation target now would ease the ultimate transition of Japanese monetary policy into a formal inflation-targeting framework—-a framework that would have avoided many of the current troubles, I believe, if it had been in place earlier.

Returning to the Great Depression, Bernanke opines that Roosevelt's key virtue was being amenable to trying anything to reverse the situation. In short, throw everything against the wall and see what sticks--a pretty apt summary of what he has (rather unsuccessfully) tried so far. That he remains aloof to his critics is thus easily explained...

But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment—-in short, to do whatever was necessary to get the country moving again. Many of his policies did not work as intended [my emphasis], but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done.

Having read the above, if you're a betting person, wager on Bernanke making some reference to inflation targeting in an elevated range (say 3-4% in Fedspeak but more like 4-6% in practice or even higher[!]). Hyperactive monetary policy it will likely continue to be. After all, what would FDR do?